Further to our recent article on the role of search funds as an alternative buyer group and the completion of the sale of the PCB fabrication and assembly business Garner Osborne, today we focus on this buyer class from a lending / debt funding perspective.
To recap, search funds are investment vehicles formed by a group of investors, lead by an experienced business operator (the “searcher”) to acquire a business. The process involves the searcher securing capital from investors to fund the initial phase of identifying and acquiring a business and the searcher being operationally involved in the running of the target business post transaction / buyout, often alongside the existing management teams, to drive growth.
Like a traditional LBO, searchers often use debt to enhance overall shareholder returns at the point of exit. However, search fund transactions present a distinct set of considerations for lenders. For example, searchers typically focus specifically on acquiring and actively managing a single business rather than investing in a portfolio of companies and whilst they may have run and operated similar businesses in the past, they are not part of the existing management team within the target.
Here, we’ll explore the key areas lenders scrutinise and what searchers can do to position themselves for success in securing debt for these types of transactions.
The importance of follow-on capital and aligned interests
One of the first things lenders will assess is whether there’s adequate follow-on capital to safeguard against underperformance post-acquisition. Covenant breaches, which can trigger a default, are always a concern. However, in search fund transactions, the situation can be further complicated by investors who might not be willing or able to put in additional equity to cure a covenant breach. This potential discord makes demonstrating a clear path to new equity critical.
Moreover, alignment of interests between the searcher and investors plays a pivotal role. Lenders want assurance that the searcher has “skin in the game” — typically in the form of a meaningful equity contribution. This shows commitment and mitigates the perception of risk.
Sector knowledge and business acumen
A core challenge for searchers is convincing lenders they have the expertise to successfully grow the acquired business given that they are not part of the incumbent management team. Without an investment track record, the burden of proof shifts to demonstrating deep relevant industry knowledge. Therefore, searchers who bring prior experience in the target sector, or at the very least closely related fields, stand a better chance of gaining lender confidence.
But technical know-how isn’t enough. Searchers must also exhibit the leadership and communication skills necessary to guide the company through its next phase of growth. This, in turn, reassures both lenders and investors that the searcher can serve as a capable bridge between all stakeholders.
A strong management team is the backbone of any search fund transaction
Given the long-term nature of search fund investments, lenders place significant weight on the strength and stability of the existing management team. A strong team, with the right incentives in place, is seen as a buffer against the learning curve that searchers may face. Lenders will scrutinise the experience and track record of each team member, looking for alignment between the searcher’s vision and the management’s commitment to executing that vision. This alignment can be created by putting in an appropriate equity incentive plan or where management have a minority stake in the target pre-transaction getting their commitment to roll that forward alongside the investors.
In cases where new leadership appointments are necessary, lenders will need confidence that these additions bring the right mix of skills and experience to complement the existing team.
Crafting a deal that works for all
Search fund transactions are bespoke rather than cookie cutter, and this means lenders will require a granular understanding of the proposed deal structure. For example, how much equity will the sellers reinvest in the business?
As noted above, a higher level of vendor roll-over equity can reassure lenders, as it aligns the seller’s interests with the future success of the business. Similarly, lenders will want clarity on how much capital will be required upfront versus how much can be deferred or linked to performance.
In cases where follow-on investments are part of the strategy, lenders will need to understand how those will be financed and what impact they might have on the business’ cash flow.
The critical role of cash flows
While stable profit and cash flow generation are a cornerstone of any debt-funded transaction, they become even more critical in search fund transactions where the buyer may be an unknown entity to the lender. Lenders will expect detailed due diligence, confirming that the target business has a solid history of profitability and cash generation. Moreover, the financial projections should be supported by recent financial performance and provide enough headroom for debt service obligations, especially given the added risk of an unproven searcher.
The road ahead for search funds in debt markets
Despite the unique challenges that come with funding search fund transactions, we expect this buyer group to continue its momentum in the lower mid-market space. The reliance on existing management teams provides a level of continuity that is attractive to lenders, and with the right preparation, searchers can position themselves to secure favourable debt terms.
Our recent experience has provided us with valuable insight into how different lenders view these structures and what steps searchers can take to tailor debt processes to meet these expectations. By focusing on the areas outlined above, searchers can not only mitigate lender concerns but also obtain flexible debt terms for long-term success.
In the end, securing debt for a search fund buyout is not just about ticking boxes — it’s about building confidence, demonstrating alignment, and crafting a deal that works for all parties involved.
Further to our recent article on the role of search funds as an alternative buyer group and the completion of the sale of the PCB fabrication and assembly business Garner Osborne, today we focus on this buyer class from a lending / debt funding perspective.
To recap, search funds are investment vehicles formed by a group of investors, lead by an experienced business operator (the “searcher”) to acquire a business. The process involves the searcher securing capital from investors to fund the initial phase of identifying and acquiring a business and the searcher being operationally involved in the running of the target business post transaction / buyout, often alongside the existing management teams, to drive growth.
Like a traditional LBO, searchers often use debt to enhance overall shareholder returns at the point of exit. However, search fund transactions present a distinct set of considerations for lenders. For example, searchers typically focus specifically on acquiring and actively managing a single business rather than investing in a portfolio of companies and whilst they may have run and operated similar businesses in the past, they are not part of the existing management team within the target.
Here, we’ll explore the key areas lenders scrutinise and what searchers can do to position themselves for success in securing debt for these types of transactions.
The importance of follow-on capital and aligned interests
One of the first things lenders will assess is whether there’s adequate follow-on capital to safeguard against underperformance post-acquisition. Covenant breaches, which can trigger a default, are always a concern. However, in search fund transactions, the situation can be further complicated by investors who might not be willing or able to put in additional equity to cure a covenant breach. This potential discord makes demonstrating a clear path to new equity critical.
Moreover, alignment of interests between the searcher and investors plays a pivotal role. Lenders want assurance that the searcher has “skin in the game” — typically in the form of a meaningful equity contribution. This shows commitment and mitigates the perception of risk.
Sector knowledge and business acumen
A core challenge for searchers is convincing lenders they have the expertise to successfully grow the acquired business given that they are not part of the incumbent management team. Without an investment track record, the burden of proof shifts to demonstrating deep relevant industry knowledge. Therefore, searchers who bring prior experience in the target sector, or at the very least closely related fields, stand a better chance of gaining lender confidence.
But technical know-how isn’t enough. Searchers must also exhibit the leadership and communication skills necessary to guide the company through its next phase of growth. This, in turn, reassures both lenders and investors that the searcher can serve as a capable bridge between all stakeholders.
A strong management team is the backbone of any search fund transaction
Given the long-term nature of search fund investments, lenders place significant weight on the strength and stability of the existing management team. A strong team, with the right incentives in place, is seen as a buffer against the learning curve that searchers may face. Lenders will scrutinise the experience and track record of each team member, looking for alignment between the searcher’s vision and the management’s commitment to executing that vision. This alignment can be created by putting in an appropriate equity incentive plan or where management have a minority stake in the target pre-transaction getting their commitment to roll that forward alongside the investors.
In cases where new leadership appointments are necessary, lenders will need confidence that these additions bring the right mix of skills and experience to complement the existing team.
Crafting a deal that works for all
Search fund transactions are bespoke rather than cookie cutter, and this means lenders will require a granular understanding of the proposed deal structure. For example, how much equity will the sellers reinvest in the business?
As noted above, a higher level of vendor roll-over equity can reassure lenders, as it aligns the seller’s interests with the future success of the business. Similarly, lenders will want clarity on how much capital will be required upfront versus how much can be deferred or linked to performance.
In cases where follow-on investments are part of the strategy, lenders will need to understand how those will be financed and what impact they might have on the business’ cash flow.
The critical role of cash flows
While stable profit and cash flow generation are a cornerstone of any debt-funded transaction, they become even more critical in search fund transactions where the buyer may be an unknown entity to the lender. Lenders will expect detailed due diligence, confirming that the target business has a solid history of profitability and cash generation. Moreover, the financial projections should be supported by recent financial performance and provide enough headroom for debt service obligations, especially given the added risk of an unproven searcher.
The road ahead for search funds in debt markets
Despite the unique challenges that come with funding search fund transactions, we expect this buyer group to continue its momentum in the lower mid-market space. The reliance on existing management teams provides a level of continuity that is attractive to lenders, and with the right preparation, searchers can position themselves to secure favourable debt terms.
Our recent experience has provided us with valuable insight into how different lenders view these structures and what steps searchers can take to tailor debt processes to meet these expectations. By focusing on the areas outlined above, searchers can not only mitigate lender concerns but also obtain flexible debt terms for long-term success.
In the end, securing debt for a search fund buyout is not just about ticking boxes — it’s about building confidence, demonstrating alignment, and crafting a deal that works for all parties involved.
